The Tragedy that is Spain

The Greek PSI will be resolved one way or the other this week. Early reports suggest a weak start and the triggering of collective action clauses and credit default swaps remain a distinct possibility. Portugal is next and, although the credit dynamics and implementation of reforms is superior to Greece, the risk remains high that it will need a second aid package and/or debt restructuring, as it is unlikely to be able to return to the capital markets in H2 2013. With 2 LTROs and collateral liberalization, the 10-year benchmark in Portugal is yielding more than 13%, compared with a bit more than 12% at the end of last year.

However, the devolution in Spain is particularly troubling. The new fiscal compact had just been signed last week, which includes somewhat more rigorous fiscal rule and enforcement, when Spain’s PM Rajoy revealed that this year’s deficit would come in around 5.8% of GDP rather the 4.4% target. This of course follows last year’s 8.5% overshoot of the 6% target.

The problem that for Spain is that the 4.4% target was based on forecasts for more than 2% growth this year. However, in late February, the EU cuts its forecast to a 1% contraction. This still seems optimistic. The IMF forecasts a 1.7% contraction, which the Spanish government now accepts.

This will be the third year in 5 that the Spanish economy contracts. Unemployment stands at an EU-high of 23.5% in February. The strong export growth seen in recent years, the best growth in the euro area, is stalling. Domestic demand has been hit by rising unemployment and government austerity. At the end of last year, the Rajoy government adopted a 15 bln euro package of spending cuts and tax increases.

Moody’s says that another 25 bln euros in savings is needed for Spain to reach its budget target. Fitch says this is unrealistic and that the overshoot not necessarily impact their credit worthiness.

Spain is already under the excessive deficit procedure (since April 2009), as are 23 of the EU 27 members. Rajoy’s revelations butt against the EU agreement that urged members to adhere to their fiscal commitments. Moreover, Rajoy struck a strident chord by saying he did not communicate this to the other heads of state because he did not have to and that Spain was sovereign.

In mid-February, a Reuters report noted that the EU believes that the Spanish government overstated the 2011 deficit to make this year’s data looks better. A recent Der Spiegel report quoted a senior source in Berlin saying: "Everybody knows that the Spanish are lying about the [deficit] figures."

Spain puts the EU in a difficult position. Belgium and Hungary have already been formally requested to address their budget shortfalls. The Netherlands is also coming under pressure after admitting recently that it is not on track to reach the 3% deficit/GDP target next year. The EU has to enforce the new agreement or lose credibility. On the other hand, enforcing it runs risks of deepening the economic downturn and fueling social and political instability, through which the EU also would lose credibility.

Some of the machinations of Spain’s government could be related the upcoming regional election in the autonomous regions of Andalusia on March 25. Rajoy’s Popular Party could win for the first time in more than 30 years. If so, the PP would govern 12 of the 17 regions. This is important because the deficit overshoot on the regional level accounted for an estimated 2/3 of the overall miss.

While Greece and the LTRO dominate the headlines, investors are already marking down Spain. Since advent of EMU, Spanish 10-year (generic) yields have been below Italy’s with the notable exception being May 2010-August 2011. However this changing and Spain is beginning to pay a premium over Italy. In part this reflects the incredible recovery in Italy after Monti became the technocrat prime minister. The Italian 10-year benchmark yield has fallen more than 200 bp this year already, while Spain’s 10-year benchmark has seen a 6 bp decline.

Perhaps an even more compelling evidence of the changed attitude toward Spain is the 5-year credit default swap is now above Italy’s for the first time in six months. At the end of last week, Italy’s 5-year CDS price fell to its lowest level since last August. The Spanish 5-year CDS price had fallen to 340 bp on Feb 8 and now stands at almost 387, about a one month high.

A confrontation between Spain and the EU is likely in the coming weeks. There is no good outcome and that what makes it a tragedy. In Greece’s case, implementation was/is a problem. Portugal is implementing reforms but still not be able to return to the capital markets as envisioned. Spain is (understandably) reluctant to implement additional austerity and wants to miss this year’s deficit target after blowing through last year’s. Can EU fine Spain? Really?

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.

Spain is also suffering a mass exodus. I have met recent emigres, who tell me how bad things are there. This does not bode well for Spain in the long term it significantly worsens their demographic situation and sets up the prospect for serious problems as the baby boomers retire and the skills are no longer in Spain. The euro is too strong for Spain to adjust to and all the gains are being sucked up by the stronger core nations.

Roberto says 7 years ago

I believe that you’re missing the point here. You seem so distant from reality. What Spain needs is a stimulus program that ends with this vicious circle of austerity measures that in turn contract growth. More cuts will lead to further deterioration. Along the way, a deep restructuring of the banking system and productive sector must be carried out, but there must be stimulus that creates a virtuous cycle. Until then, keep on writing about your ideas of Spain from your dark rooms in the US. Reality will prove you wrong.

Roberto, I have to agree with Marc here. He was very diplomatic in response. Me, I will be more blunt: I honestly think you are the one missing the point. As I like to say “Spain is the perfect example of a country that never should have joined the euro zone”:

Spain (and Ireland) had a budget surplus and low government debt before the crisis. Spain (and Ireland) saw Maastricht Treaty compliance while France and Germany were over on both the deficit and debt to GDP hurdles. That tells you this crisis is not a government debt crisis. It’s a balance of payments crisis – and it can’t be fought off with austerity alone.

It is no-win situation for Spain and the EU as Marc says. The EU has laid down the law and just because Spain has been a model before the crisis and during the IMF program doesn’t mean they can get special treatment. We know from Germany and France breaking the 3% hurdle that what’s good for the goose is good for the gander. So now we are likely to see a response from the EU that is anti-growth and makes things worse.

Bottom line: the EU is in a policy cul-de-sac. The whole austerity fixation is wrong-headed and creates these no-win policy dilemmas. It will only get worse until they realise it is not a government debt but a private debt and balance of payments problem.

David Lazarus says 7 years ago

It is also a private banking sector crisis. Both Spain and Ireland had huge property bubbles financed by banks. These are unwinding and dragging down the sovereign because they are being forced to bail out the banks.

Austerity is the perfect solution to destroy the EU, and they are force feeding it to every nation. I do agree with Roberto in that a stimulus program to increase aggregate demand is needed but that has now been criminalised by the EU’s latest treaty that imposes balanced budgets.

I agree Roberto, Spain needs to boost aggregate demand. I simply do not see this as a practical political issue now. Surely the Rajoy government that got elected partly on its austerity program is not going to boost econimic stimulus in any kind of meaningful way. I did not think I took a stand regarding what Spain ought to do, I tried depicting a no-win situation for Spain and the EU. A tragedy if you will, not a whodunnit.

Roberto says 7 years ago

Spain was by no means a model before the crisis. Labour market was dysfunctional, salaries very low and the whole economy was based on real estate and civil works. Government spending was wasteful and severy biased towards civil works. There was an infrastucture deficit before the nineties which got solved but they didn’t seem to care.

We’re in the Eurozone now, so there’s no use crying over spilled milk. The bottom line here is how we fix it. I have some ideas, some of them are very radical but seem appropriate from the ‘fighting ground’:

1. Clean-up of the banking sector: Selective default of bust banks and saving banks. By this I mean, taking away the deposits from them as they did in Iceland and let them go bust. This is the principle of a market economy, wrong bets should imply losses, not bail outs by the ECB through the LTRO.
2. Fiscal reform: Progressive taxation and prosecution of massive tax evasion (this will yield according to a very well informed estimate 72 Bn € https://www.gestha.es/?seccion=actualidad&num=221). Big corporation and wealthy families account for the lion’s share of tax evasion.
3. Capital controls to avoid what’s going on in Greece
4. Boosting the economy by keeping in mind where we have gone wrong in the past. We have competitive advantages in renewable energies and a huge market in Latin America. Young people are educated and it’s just a question of putting them to work. There are a lot of entrepeneurs in Spain, it’s just that they don’t get the money that goes to bail out the banks or to feed the bunch of contractors and achievers that live from the government (see El Pais https://economia.elpais.com/economia/2012/03/02/actualidad/1330712282_179577.html )

In the end, we have two choices: end up beaten up like Greece or fight for our destiny like Iceland. Power lies in the people not in a bunch of bureaucrats in Frankfurt that nobody has chosen. I don’t how this fits with remaining in the eurozone, neither have I read that Germany or the majority of the countries can actually expel Spain if we question the rules.

If I have to choose between staying like now – with the country almost falling apart – or exiting the Eurozone and trying to fix the problems, I’ll go for the latter.

Spain and Ireland WERE the model from a public debt perspective as they both fulfilled the criteria on debt and deficits before the crisis. And they have been the models in terms of implementing austerity programs as well. So when I say “the model” I am pointing to this. The reality is that low government deficits or surpluses are balanced by equivalent and negative changes in private sector savings.

People don’t seem to understand this. Spain and Ireland’s ‘model’ numbers were due to a private sector binge and now that indebtedness cannot be worked off via devaluation due to the euro. This creates debt stress and lowers consumption demand, making for an unsolvable problem within the current political economic framework. All of the ideas you have are fine but by no means will it have any bearing over the medium term on Spain’s ability to meet its targets.

What Spain and Ireland in particular need is a boost to demand, preferably from the core (Germany, Netherlands, Austria, etc) to change the balance of payments situation. Watch how this economic situation develops and you will see what I am talking about.

Oldrich says 7 years ago

All right, but subjectively it doesn’t feel like that. Have been on trip last week in Barcelona where there was a huge telecommunication sector conference – literally all hotels were full), restaurants were full, people are shopping ( Corte Ingles in the center of Barcelona was full) and certainly the overall price level of consumer goods and of food is pretty high. Yes it is true that you do not see that many luxury cars.
Just some observations – I am myself not into these sort of things but my companions wanted to see the Barca stadium (not the actual match but just a tour round the empty stadium). And it isn’t cheap. And besides the foreigners there were also good many Spaniards. And in the evening my companions went to the Cirque du Soleil (which is at this moment performing in Barcelona and it was chock-full….

Roberto says 7 years ago

I totally agree with you Oldrich. GDP hasn’t fallen by much in the last years but unemployment has soared. We’re in a fiscal crisis, the real economy is not fit but not destroyed, it has to be boosted and reestructured. Further cuts in public spending will make the fiscal crisis worse.

There are no jobs but there is informal employment and social fabric is still pretty strong in Spain. The families make up for what the State doesn’t cater for. Nothing is broken yet but I’m starting to see the cracks. Don’t be misled by our character, even in extreme situations, Spanish people tend to be happy.

It’s not a fiscal crisis at all, Roberto. Spain has better debt ratios than France, better debt ratios than Germany. Spain’s problem is a intra-euro zone balance of payments problem and private sector debt that came from a property bubble. It’s the same problem in Ireland as well. If it were fiscal, then Spain would have had deficits throughout the 2000s. A fin de cosas, el problema para España es el crecimiento económico.

Roberto says 7 years ago

I see your point but it’s not so different than mine. No stimulus will come from the core, only austerity. Spain is not an exporting country. Internal devaluation is not working and will create more pain. It’s not working now and will bring the economy down.

We have to sort out our own mess but for that the state needs resources which have to come from taxes. Tax collection has fallen much more than GDP which clearly reflects that tax system was wrong, strongly based on real estate taxes. Gov’t surplus before the crisis was a real estate delusion.

Tax evasion is huge, especially in large corporations. Once the government has the money (and not through bond issues which create more debt) it will restart spending and the economy will be back to life. It is a fiscal cum growth crisis. Without state intervention the private sector will take years to deleverage. Only government policy may boost economic activity.

Anyway, the current government doesn’t share any of the views expressed here and will go on with austerity measures. Who knows how much damage will be made?

David Lazarus says 7 years ago

Spain is a agricultural exporter, but they do not benefit from a devalued currency. A better solution are increases in capital gains taxes at the same marginal rate as income. This will raise more money from the wealthy as they gain primarily in capital gains. Extending capital gains taxes to homes will also stop speculation by individuals. As for corporations maybe the only solution is to tax them with unitary taxes.

Roberto, I agree with you 100%. I know you’re optimistic about how Spain will get through this. And the place I see cause for optimism is in Rajoy signalling he won’t try to meet targets. The targets are unreasonable and they’ll kill the economy. Let’s see how this develops politically because Marc’s post points to the problem with letting Spain flout the targets already set, even if that’s the reasonable thing to do.

Yes but such an increase in demand from the core is unlikely. They will want to maintain their surpluses because of the uncertainty over their own banks. Austria’s banks have problems in the east. German banks have problems everywhere but Germany. The Dutch banks have a big property bubble to deal with.

The real problem is excess debt everywhere holding up asset bubbles that are still deflating. Roberto’s solution of allowing banks to default does reduce overall debt which is what helped Iceland and is hindering Ireland and Spain, where it is not being allowed to happen.

Capital controls would have also stopped the bubbles growing so large if German funds could not have found their way into the periphery so easily. Colectively the world of economics and finance have forgotten the lessons of history, yet we are bailing them out with tax payers money. I have no problems with stimulus programs to rebuild the economy but until the mal- investment is cleared all that it does is support bubbles.

Exactly. The periphery’s only hope is private sector defaults and an economic reboot after those debts have been written down. There is no balance of payments change coming to the euro zone.

revelo says 7 years ago

What Spain (and Greece and the other PIIGS) need is a whomping big tax on land. I don’t know about Ireland, but the other countries all have a fascist history, and one of the legacies of fascism is a tax system that privileges land rent (whether explicit or imputed) over other forms of income. The fascists all understood that the best way to ally the peasants to the plutocrats was to give the peasants a little piece of land to call their own. Of course, the land owned by the typical peasant is so small that they can’t live off its rent, like the big landowners, and effectively they are workers, not rentiers. But this is not how they see themselves. Because the peasants has been deluded into thinking of themselves as members of the landed gentry, they vote for a tax system that punishes labor and leaves land untaxed, thereby raising the cost of living and thus burdening laborers still further and imposing a cost structure handicap on businesses. Compare with Germany, whose tax structure makes industry the best way to get rich, rather than land ownership. Germany, of course, has a much lower rate of home ownership than the Mediterranean countries. The Netherlands goes so far as to tax imputed rent, which is another way to punish land-hoarding rentiers and thereby relieve the burden on laborers and wealth-producing industry.

The Angle-Saxon countries (Britain, US, Australia, Canada) also privilege land-ownership. Historically, this wasn’t a big problem in last 3 of these countries, because there was plenty of land to go around. But it was historically a major problem in Britain and is both a consequence and cause of the rigid class structure there. The housing bubbles in these 4 countries are a result of privileging land-ownership. The bursting bubble has had devastating effects in the US and will have even more devastating effects on the other countries. Not sure if Ireland follows the Anglo-Saxon/PIIGS model of privileging land-ownership or not, but I suspect it does.

The whole developed world may eventually come round to the idea of taxing land heavily, since capital is becoming increasingly mobile and land is the only thing that can be taxed in order to pay for entitlements. But the land-owners won’t like that. That is why I wrote “may” rather than “will”. The alternative is we lose democracy to some extent and entitlements are cut in order to preserve the privileges of the land-owning plutocracy.

David Lazarus says 7 years ago

Ireland also have a rentier class that owned most of Ireland for most of its history and just as extreme as in England or Spain. A better way would be high capital gains taxes on land and property. By doing this it will create a bigger incentive for industry. It will also lower rents for industry. The problem with high real estate prices is that it drives up the fixed costs of employment and businesses alike. If you want to start a new business rising real estate might actually hinder the creation of new businesses which are the real job creators. So in effect low property taxes are effectively a tax on jobs, except that the gains are taken by rentiers rather than the new business in the form of higher rents. It also distorts banks lending criteria. If banks find that property has the benefits of appreciation and permanence then it makes sense to lend to support land purchase rather than finance companies investment which has more risks.

A land tax must be combined with higher capital gains taxes on that land otherwise it will be avoided if there are loopholes. Your comment about the Netherlands land tax has not avoided a massive property bubble there. Also as you commented that capital is highly mobile so land taxes
make sense except that governments have actually decided to tax labour instead via consumption taxes. Personally I think that higher and progressive income taxes and lower consumption taxes would actually help lower income families save more, which will actually help long term median savings rates.

Very interesting post. Thanks for your thoughts there. Michael Hudson talks a lot about this kind of thing and in terms of dealing with tax evasion in Greece, Spain and Italy, it makes sense to target land. If austerity continues much longer this could be something that comes into play.